Look before you lease

Gil Gullickson | Mar 01, 2001

Here's how to determine whether buying or leasing is the better deal.

Several years ago, Howard Doster, a Purdue University agricultural economist, and his son labored over a spreadsheet that compared an equipment company's leasing option with borrowing or paying cash. Each time, buying or borrowing beat leasing.

This stumped his son, who possesses a master's degree in business administration. Doster recalls, My son asked me, Don't farm magazines often tout the virtues of leasing? I said yes. Then he said, That's it! Those guys in that equipment company's finance department went to the same finance school that I did. They learned that marketing is all about perception. If the market perceives that leasing is better, the customers will follow.

That anecdote reveals a great deal about leasing equipment. Sure, leasing is a way to obtain premium machinery at a low initial cost. Leasing also enables you to have payments that are lower than those for most conventional loans. And if you need equipment just for a short time, leasing frees you from expensive ownership costs.

Yet leasing also enables machinery companies to move equipment. This benefits their bottom line, and not necessarily yours, Doster says.

It's possible to make lease terms better than the buying terms, he adds. Generally, however, when I run the numbers, the buy terms come out better for the farmer.

Leasing can be beneficial in certain situations. But before you lease, pore over the terms with your accountant or other financial adviser. Look at lease terms versus terms you can receive if you borrow money, says Gary Bredensteiner, director of farm management operations for the University of Nebraska. If lease terms are more economically favorable than those for borrowing funds, do it.

Here are some tips we've rounded up from experts to help you determine if you're a leasing candidate.

For starters

Two types of leases exist, says William Edwards, an Iowa State University agricultural economist. Under a capital lease, you make a series of regular payments over several years. When the lease expires, you either return the machine to the dealer or lease company, or purchase the machine for close to fair market value.

The Internal Revenue Service treats a finance lease as a conditional sales contract. Because the agency considers you to be the machine's owner, you must place it on your tax form's depreciation schedule. Many finance leases are essentially balloon payment loans established for three to five years. The difference is that at the end of the lease period, you can still choose to either return the machine to the dealer and give up ownership, or make a final balloon purchase payment. The final buyout price can widely vary, because the finance lease is not taxed as a true lease.

So, should you lease?

First, determine your financial status. Generally, unless there's a real capital problem for you, it's cheaper to buy or own if you're intending to use the product for a number of years, says Les Peterson, president of Farmer's State Bank, Trimont, MN. We've run comparisons for borrowers and, generally, ownership is the cheaper route.

If you purchase machinery outright, you usually will spend less in the long run, says Edwards. This is especially true for equipment you will own for five to 10 years or more.

Yet leasing has attractive attributes even if you are in good financial shape. Generally speaking, the payments for leases are less than those for loans, says Preston Kranz, trade credit representative for Farm Credit Services of America, Sioux Falls, SD. You also need little initial investment to obtain needed equipment.

You'll also have a lower cash outlay with no down payment, reminds Paul Rauenbuehler, agricultural marketing manager for Case Credit.

However, David Frette, a Washington, IN, certified public accountant, cautions that, although your monthly payments are less with a lease, you'll have no equity at the end of it. I see a lot of that with combines, Frette says. Farmers who lease combines keep leasing them because they have no equity built up.

Consider your tax situation. Leasing has tax perks. You may write off the full amount of the lease in the year that you pay it. With a purchase, you may just deduct the interest payment.

But farmers forget that depreciation is also deductible as a business expense over seven years under a purchase, says Terry Kastens, Kansas State University extension economist. When you add interest and depreciation, the tax advantage is often much more than that with a lease payment, at least in the early years.

However, when you lease, the machinery or finance company, which is the lessor, obtains the faster tax write-off associated with ownership; it may then pass on part of those gains to the lessees you and other farmers in the form of lower lease payments.

Consider your tax bracket. Conventional wisdom dictates that farmers in high tax brackets can best take advantage of leasing, due to the 100% lease write-off. However, the reality is often the opposite: Farmers in low tax brackets often have the most to gain from leasing. For example, Kastens says the best candidates for leasing are high-profit farmers in the low 15% income tax bracket.

That seems impossible, to have high profits and low income tax rates, Kastens says. But it's not as bizarre as you'd think. If you have a successful growing farm that's highly profitable, you can defer income taxes for many years. If you keep having more crop expenses on more acres in each successive year, you can keep writing it off and pushing back the income tax. Those types of people can best utilize the tax benefits of leasing.

Examine Section 179 deductions. Tax perks from leasing can occur when you exhaust the $24,000 deduction limit under Section 179 of the 1040-tax form. If you need to buy machinery late in the year but have already exhausted your Section 179 limit, you can lease it and write off the entire payment.

Peruse your balance sheet. A finance lease can help snap it into shape, because it won't show up on your balance sheet, Edwards says. By excluding this liability, your balance sheet may help you garner financing dollars in other areas.

Debt not showing up on a balance sheet can be positive for a young farmer who is trying to make things work, Frette says.

Yet this can create a false sense of security by masking your true financial situation. This can become negative if you forget that the lease is in fact a liability, Frette says. You still owe that lease payment.

Plus, this perk is only limited to a finance lease. The Farm Financial Standards Task Force recommends that capital leases be shown on the balance sheet, Edwards says.

When you add interest and depreciation [of a purchase], the tax advantage is often much more than that with a lease payment, at least in the early years. Terry Kastens Kansas State University extension economist

Consider your mechanical abilities. Do your hands suddenly sprout six thumbs when it comes to fixing old machinery? If so, leasing may be for you. It can enable you to run new equipment with minimal potential for breakdowns and costly repairs.

With a purchase, you figure that since you own it, you might as well keep it, says Bob Stevenson, whole goods administrator with Midwest Agridevelopment Corporation, Jamestown, ND. Then your repair costs can go through the roof. Your purchase could cost more than a lease.

Leasing also may appeal to you if you want the latest technology. In that case, you are better off leasing because you'll be able to better update equipment in the most cost-efficient matter, Rauenbuehler says.

However, this must be balanced against lease costs, Kastens says. The idea is if I lease, I can run new equipment and keep up with technology. The truth is, you have to pay the piper. If leasing causes you to update machinery more often, you'd better have the profitability to support that style of machinery management. That's why I often find that the best leasing candidates are high-profit farmers in the low 15% tax bracket.

Determine your acreage size. The advantage of ownership exists if you put a lot of hours in your machine, says Jorge Vicura, a farm manager for the Haskell Agency, Huron, SD. But if you raise just a small acreage of high-value mint oil, why own the tractor? You won't see the returns of the ownership.

If you use an implement for just a short period of time, leasing may also pay. Why own a fertilizer spreader that you'll use just 50 hours out of the year, when you might be better off leasing it? asks Don Peterson, South Dakota State University extension agricultural economist. Or maybe your tractor is in the shop. You could get a short-term lease on a replacement.

Examine your need to preserve capital. Even if you're in good financial shape, leasing can be a way to direct capital into other areas. If you don't want to tie up money in equipment, leasing can be a good option, Rauenbuehler says. With a lease, you don't build up equity, but you also don't tie up cash.

What's the interest rate?

Now you're getting serious about comparing purchasing versus leasing a piece of equipment. One source of frustration is trying to compare the interest rates of the two options. Unlike loans, interest rates don't accompany leases.

In some cases, you may obtain interest rate equivalents from the leasing company. I have no problem in telling an individual what it will be on an equivalent interest basis, because we will do both loans and leases for the ag community, says Glen Johnson, president of Midwest Leasing Services, Grand Island, NE.

Still, it's difficult to compare leases with loans, Frette says. The way that the lease figures interest charges and the way that I figure interest charges are not the same, he adds.

If you don't want to tie up money in equipment, easing can be a good option. With a lease, you don't build up equity, but you also don't tie up cash. Paul Rauenbuehler agricultural marketing manager Case Credit

In Frette's experience, leases that tout 5 to 6% interest rates end up costing farmers more. For example, damage deposits frequently mask higher interest charges. Some four-year leases that Frette has analyzed include an up-front $10,000 damage deposit that a farmer will not receive back until the lease expires.

As far as I'm concerned, that's the same as a down payment, Frette says. You get no return out of that money. Eight percent interest over four years costs you $3,200 in interest. Most lease interest applications that I've worked with don't take that into account.

Keep your eyes open

Maybe leasing doesn't fit you. Still, there are times when leases are extremely attractive. Kastens points to the winter and early spring of 2000, when farmers under financial stress in the southern U.S. turned in Deere tractors at the expiration of a three-year lease. Rather than unload them into a soft machinery market, Deere instead leased the tractors for another three-year cycle for low payments. As a result, farmers received tractors at a low cost.

You should be aware of an occasional disequilibrium in the market when leasing becomes advantageous, Kastens says.

You also may use a mix-and-match leasing strategy, like Bob Wietharn, a Clay Center, KS, farmer and Team FIN member, did. I don't normally trade equipment unless I can pay cash, he says. Normally, you can also obtain financing cheaper than what leases cost.

However, Wietharn does sell center pivot irrigation units under a leasing program. He also has leased one on his own farm. Under the program, four payments with an 8.45% interest equivalent rate and a final buyout payment follow an up-front payment.

Most people do it for tax reasons, Wietharn says. You can lease it on December 1, make a lease payment and write off the full amount of the lease. If you just purchase the unit, you can't write it off on your taxes.

Though leasing isn't the answer in all cases, it may fit certain situations. But don't assume that a lease will be better off than a purchase, Frette says. Just do the numbers first.

Not satisfied with leasing or purchase options? There's a third way to acquire machinery the rollover purchase plan.

In this scenario, a farmer purchases a new or nearly new implement from a dealer, expecting to return it for another model after one year or season. Often, he finances the purchase with a company loan that accrues no interest until the date to trade. At that point, the farmer makes the cash payment that's sometimes based on the hours of use accumulated on the model he is returning.

So how do leases, purchases and rollovers compare? The table below compares the cash outlays for an outright purchase, a five-year operating lease and a yearly rollover of a new $150,000 combine. It also takes into account depreciation, interest and repairs as tax deductions. Recaptured depreciation at the end of the five years also creates an additional tax. Taxes are assumed to affect cash flow in the year after they are reported.

The present value is the true cost of each plan over five years, taking into account the time value of money. The lease plan calls for a $25,000 annual lease payment. Under the rollover plan, the cost to trade each year is assumed to be $27,500.

Everything considered, the new present outlays of the purchase and lease options are nearly equal. The rollover plan is more expensive, but remember that you're getting a new machine every year that's under warranty, says William Edwards, Iowa State University agricultural economist.

Comparison of machinery acquisition plans using after-tax dollars

Purchase

Lease

Rollover

Initial

-$150,000

-$25,000

-$27,500

Year 1

5,623

-16,250

-21,877

Year 2

9,633

-16,660

-16,426

Year 3

7,172

-16,969

-16,737

Year 4

5,391

-17,290

-16,750

Year 5

65,060

7,739

11,929

Year 6

-4,914

0

-2,014

Total cash outlay

-62,041

-84,791

-89,375

Net present outlay

-74,259

-74,942

-79,646

Courtesy of William Edwards, Iowa State University agricultural economist, and Ray Massey, University of Missouri agricultural economist